2019 CFA level 3 qbank reading 29 active equity investing portfolio construction answers

10/12/2018 Learning Management System Question #1 of 24 An active equity portfolio manager is benchmarked by their domestic large-cap equity index If the manager signi cantly lowers the allocation to cash in the portfolio by buying benchmark securities, this is most likely to: A) decrease active risk and increase absolute risk B) increase active risk and decrease absolute risk C) increase active risk and increase absolute risk in Explanation bo ok c (Study Session 14, Module 29.3, LOS 29.d) en tre Cash is likely to have a low correlation with the benchmark and hence lowering the allocation to cash and buying benchmark securities is likely to increase the correlation of the portfolio with the benchmark and hence lower the active risk of the portfolio The absolute risk of the portfolio measured by standalone standard deviation is likely to increase as the portfolio is allocating to more risky assets Related Material m SchweserNotes - Book o Question #2 of 24 w w Exposure to rewarded factors can be achieved through w A) Systematic active management approaches only B) Discretionary active management approaches only C) Both systematic and discretionary active management approaches Explanation Systematic approaches are likely to explicitly target exposures to rewarded factors that are expected to generate excess returns Whilst a discretionary approach may be less formal in its nature, the judgement employed by discretionary managers could be aimed at identifying better factor proxies that are expected to outperform (Study Session 14, Module 29.1, LOS 29.b) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447526/print 1/16 10/12/2018 Learning Management System Question #3 of 24 An analyst estimates the following data for two active equity fund managers: Manager Breadth Active Risk Transfer Coe A 50 8% 0.55 B 100 8% 0.55 cient manager A is closest to: en tre A) times the information coe cient of manager B in If manager B has the same excess return as manager A, then the Information coe cient of B) 1.4 times the information coe cient of manager B C) 0.7 times the information coe cient of manager B bo ok c Explanation According to the fundamental law of active management: E (RA ) = I C√BR ‾‾‾σRA T C Where m E(RA) = excess return of the manager w w BR = breadth o IC = Information coe cient σRA = active risk w TC = transfer coe cient The excess return of manager A = ICA x √50 x 0.08 x 0.55 = ICA x 0.311 The excess return of manager B = ICB x √100 x 0.08 x 0.55 = ICB x 0.44 If the manager's excess returns are the same this implies ICA x 0.311 = ICB x 0.44 And, hence, ICA = ICB x (0.44/0.311) = ICB x 1.4 (Study Session 14, Module 29.1, LOS 29.a) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447526/print 2/16 10/12/2018 Learning Management System Question #4 of 24 A security has an active weight of 10% and the covariance of the security's active returns and portfolio active returns is 0.005 The contribution of the security to portfolio active variance is closest to: A) 0.0005 B) 0.05 C) 0.005 in Explanation Related Material SchweserNotes - Book m Question #5 of 24 bo ok c (Study Session 14, Module 29.3, LOS 29.d) en tre The contribution of a security to active variance is the product of the security's active weight and the covariance of the security's active returns and portfolio active returns In this case this equals 0.1 x 0.005 = 0.0005 o Manager A generates excess return by maintaining a consistent positive active exposure to the w w size factor Manager B has the same benchmark and generates excess return by varying their exposure to the size factor according to their view on when the factor will outperform Both managers are highly diversi ed According to the building blocks of active management, which w manager is most likely to be generating return from alpha skills? A) Manager B only B) Both Manager A and Manager B C) Manager A only Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447526/print 3/16 10/12/2018 Learning Management System Manager A is generating excess return through maintaining a di erence in factor weights This source of return is not considered alpha since it is not related to manager skill in identifying mispriced securities and can be easily passively replicated Manager B is engaging in market timing of the size factor in order to generate excess return, which requires skill in understanding when the size factor is likely to outperform and when it is likely to underperform This skill is deemed to be alpha (Study Session 14, Module 29.1, LOS 29.a) Related Material in SchweserNotes - Book en tre Question #6 of 24 An active equity investment manager has a target active risk of 8%, a maximum sector deviation of 12% and maximum risk contribution from a single security of 2% This manager is A) Closet Indexer B) Sector Rotator C) Concentrated stock picker m Explanation bo ok c best described as a: w w o A high maximum sector deviation and a signi cant target active risk suggests this manager is a sector rotator A closet indexer would have signi cantly lower target active return, and a concentrated stock picker would likely have higher maximum risk contribution from a single security and a lower maximum sector deviation (Study Session 14, Module 29.2, LOS 29.c) w Related Material SchweserNotes - Book Question #7 of 24 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447526/print 4/16 10/12/2018 Learning Management System James Greco, CFA, is an investment analyst working as a consultant to institutional clients One of his clients has asked him about recent innovations in factor-based equity investing In response to his client's questions, Greco makes the following two statements: Statement 1: 'Managers that have the ability to short sell in their portfolios are more likely to generate higher information ratios when pursuing diversi ed factor exposure strategies than long only managers' Statement 2: 'Due to the ability to short sell and the inherent hedging that entails, the long term returns of long/short managers is always expected to be lower than those of long-only managers' B) Statement only C) Statement only bo ok c Explanation en tre A) Both Statement and Statement in Which of Greco's statements is correct? m Statement is correct Factor returns are usually built from long/short portfolios, for example the size factor is represented by a portfolio that is long small cap securities and short large cap securities Hence the ability to target a diversi ed exposure to di erent factors relies upon the manager being able to short sell securities It is likely that a long-only manager will have a large exposure to the market risk factor that will dominate other factors and hence not be su ciently diversi ed across factors w w o Statement is incorrect Long/short managers can employ signi cant leverage to magnify expected returns A manager that employs signi cant leverage could match or exceed the expected returns of a long only portfolio, but may employ leverage levels that some investors are not comfortable with w (Study Session 14, Module 29.5, LOS 29.h) Related Material SchweserNotes - Book Question #8 of 24 When a benchmark security held in an active portfolio is replaced with a similar security that is not held in the benchmark, the most likely outcome is: A) Active Share increases by more than active risk https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447526/print 5/16 10/12/2018 Learning Management System B) Active Share decreases and active risk increases C) Active Share and active risk both increase by similar proportions Explanation Swapping a security that is in the benchmark for a security that is not in the benchmark will certainly increase Active Share because Active Share is a direct measure of the amount of the portfolio that is not included in the benchmark Active risk however will not necessarily increase since it is a measure of the volatility of relative returns – this is unlikely to increase if the new security that is introduced in to the portfolio behaves in a similar way to the benchmark security that was originally held in the portfolio (Study Session 14, Module 29.2, LOS 29.c) in Related Material en tre SchweserNotes - Book bo ok c Question #9 of 24 Factor timing is a technique most likely employed by a strategy that is: A) Top down and systematic B) Bottom up and systematic o Explanation m C) Top down and discretionary w w Factor timing Is a di cult challenge, and as such there are few successful systematic strategies that have integrated factor timing in their approach The judgement required to enact successful factor timing usually means the strategy is top-down and discretionary w (Study Session 14, Module 29.1, LOS 29.b) Related Material SchweserNotes - Book Question #10 of 24 All of the following characteristics are features of the 'well-constructed portfolio' except: A) The portfolio delivers results consistent with investor expectations in a coste cient way https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447526/print 6/16 10/12/2018 Learning Management System B) The portfolio delivers results consistent with investor expectations in a risk-e cient way C) The portfolio guarantees excess returns relative to the benchmark Explanation The well-constructed portfolio does not guarantee excess return vs the benchmark It is designed to deliver results consistent with investor's risk and return expectations in a cost and risk-e cient way (Study Session 14, Module 29.5, LOS 29.g) Related Material en tre in SchweserNotes - Book Question #11 of 24 An active equity investment manager follows a strategy which has the following investment bo ok c constraints: Maximum position size is the lesser of 5x the index weight or the index weight plus 2% No position size is allowed that represents more than 10% of the security's average daily volume (ADV) o index m No investment is allowed in any security whose index weight is less than 0.1% of the w w Details of the fund and benchmark index are as follows: Fund size: $500 million w Approximate number of positions: 350 Approximate total market capitalisation of benchmark index: $10 trillion Approximate daily trading volume of smaller securities in the benchmark: 0.5% of shares outstanding The level of assets under management at which the manager's strategy is likely to be a ected by liquidity and concentration constraints is closest to: A) $10 billion B) $1 billion C) $2 billion Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447526/print 7/16 10/12/2018 Learning Management System The manager cannot invest in stocks whose market cap is below approximately 0.001 x $10 trillion = $10 billion The ADV of this smallest cap holding would be about 0.005 x $10bn = $50 million The maximum absolute position size for this smallest cap holding is therefore 0.10 x $50m = $5 million The maximum position for the smallest cap security is the lesser of x 0.1% = 0.5% and 0.1% + 2% = 2.1% This means the maximum position size in the fund for the smallest cap security is 0.5% If the manager cannot hold up to 0.5% of the fund in the smallest capitalization position, then the ability to carry out the strategy is potentially impaired Related Material Question #12 of 24 bo ok c SchweserNotes - Book en tre (Study Session 14, Module 29.4, LOS 29.f) in Given that the manager cannot hold more than $5 million in the smallest capitalization holding, this means the ability to carry out the strategy is impaired by illiquidity when AUM reach $5,000,000/0.005 = $1 billion m An active equity investment manager has the following four risk constraints: o Liquidity constraint: It should always be possible to liquidate 85% of the portfolio in 10 trading days or less without su ering signi cant market impact costs w w Leverage: Explicit leverage is not allowed Leverage using derivates is allowed but restricted to a portfolio assets/equity ratio of 1.5 w Maximum tracking error of 5% per annum The % Conditional VaR should not exceed 3% How many of these constraints are heuristic in nature? A) Two B) Three C) One Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447526/print 8/16 10/12/2018 Learning Management System Heuristic risk constraints are based on experience and deemed good practise without rigorous backing of empirical evidence The liquidity constraint and the leverage constraint are examples of such heuristic risk constraints The tracking error and Conditional Var constraints are formal constraints in that they are statistical in nature and directly linked to the distribution of the returns of the portfolio (Study Session 14, Module 29.3, LOS 29.e) Related Material SchweserNotes - Book in Question #13 of 24 en tre Which of the following active equity managers is likely to generate most of their active return from idiosyncratic risk? A) A manager following an enhanced indexing factor-tilt approach bo ok c B) A manager following a quantitative factor-based approach C) A stock-picking manager following a fundamental approach Explanation w w o m Idiosyncratic risk comes from large concentrated positions Quantitative factor-based managers tend to hold many hundreds of position to generate their desired exposures and therefore will likely diversify away idiosyncratic risk Similarly, an enhanced indexing manager will hold a broad portfolio very close to the benchmark index and therefore is likely to be diversi ed Fundamental stock-picking managers are likely to hold fewer positions since they generate few high-conviction ideas through time consuming research, hence are likely to be the least diversi ed and have the highest contribution to active return from idiosyncratic risk factors w (Study Session 14, Module 29.1, LOS 29.a) Related Material SchweserNotes - Book Question #14 of 24 Which of the following statements regarding risk constraints is most accurate? A) Formal risk constraints are appropriate for fundamental managers, heuristic risk constraints are appropriate for quantitative managers https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447526/print 9/16 10/12/2018 Learning Management System B) Both Heuristic constraints and formal constraints are equally likely to be appropriate for both fundamental and quantitative managers C) Heuristic risk constraints are appropriate for fundamental managers, formal risk constraints are appropriate for quantitative managers Explanation in Fundamental managers are likely to run more concentrated portfolios and hold fewer positions – this increases the estimation errors for return distributions and makes the use of formal risk constraints that directly relate to estimate return distributions less useful Hence fundamental managers are more likely to nd heuristic risk constraints more appropriate Conversely, quantitative active equity managers are likely to integrate formal risk constraint measures into portfolio optimizers when constructing their portfolios (Study Session 14, Module 29.3, LOS 29.e) en tre Related Material Question #15 of 24 bo ok c SchweserNotes - Book All else equal, the well-constructed portfolio for an active equity investment strategy will most likely have m A) A greater number of positions and lower active share o B) Fewer positions and higher active share w w C) A greater number of positions and higher active share Explanation w Managers that can achieve the desired exposure to risk factors with fewer positions are more likely to be focussed on risk management and are therefore behaving in a risk-e cient manner All else equal, portfolios with a higher active share are preferable since these portfolios will bene t most from the alpha skills of the managers and should therefore have higher expected returns (Study Session 14, Module 29.5, LOS 29.g) Related Material SchweserNotes - Book Question #16 of 24 https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447526/print 10/16 10/12/2018 Learning Management System Forward looking risk estimates are required for: A) Formal risk constraints only B) Heuristic risk constraints only C) Both formal risk constraints and heuristic risk constraints Explanation in Formal risk constraints are directly linked to the expected return distribution of the portfolio and as such require estimation of the distribution of portfolio returns Heuristic risk measures on the other hand are based on experience and perceived good practice and not directly related to the expected return distribution of the portfolio, hence estimation is not required (Study Session 14, Module 29.3, LOS 29.e) en tre Related Material Question #17 of 24 bo ok c SchweserNotes - Book Two active equity investment managers have similar sized investment funds and the same investment universe Active equity manager A follows a concentrated stock-picking strategy m with a high turnover of portfolio positions Active equity manager B follows a diversi ed factor o exposure strategy with a low turnover of portfolio positions Which manager is most likely to be w w able to sustain a higher level of Assets Under Management (AUM)? A) Manager B w B) Manager A C) Both managers are likely to sustain a similar level of AUM Explanation All else equal, managers with lower turnover and smaller positions are likely to have lower market impact costs due to the less frequent need to trade and the lower need for liquidity from markets in order to establish positions in the fund Manager B is likely to have signi cantly more securities in their fund than manager A since they are diversi ed With a lower portfolio turnover, it is likely manager B will be able to sustain a higher level of AUM than manager A due to the lower market impact costs of the strategy (Study Session 14, Module 29.4, LOS 29.f) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447526/print 11/16 10/12/2018 Learning Management System Question #18 of 24 An investor is most likely to consider introducing short selling into a long-only portfolio when their primary concern is: A) Hedging B) Earning long-term risk premiums C) Capacity in Explanation bo ok c en tre The ability to short-sell securities allows managers to better hedge risks they are unwilling to face Short selling strategies tend not to have the capacity of long only strategies due to being constrained by the availability of securities to borrow, hence managers who are concerned with scalability and capacity issues would be less inclined to use short selling strategies Long term risk premiums tend to be earned by going long risky securities, therefore managers focussed on earning long term risk premiums are not likely to consider introducing short positions into their portfolios (Study Session 14, Module 29.5, LOS 29.h) Related Material m SchweserNotes - Book w w o Question #19 of 24 Which of the following factor-based strategies is least likely to su er signi cant scaling issues w due to increased slippage costs caused by higher levels of assets under management (AUM)? A) Short-Term Reversal B) Size C) Value Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447526/print 12/16 10/12/2018 Learning Management System The size risk premium is earned by overweighting small cap stocks and underweighting large cap stocks Due to the lower trading volume of small cap stocks, slippage costs are likely to increase as a manager scales up in asset size The short-term reversal factor risk premium is earned by selling recent outperformers and buying recent underperformers on a short-term investment horizon This is likely to have a relatively high turnover compared to other more passive factor strategies and as such will likely have higher slippage costs as the manager's assets under management increase The factor with the most scalability is the value factor since this can be earned through passively holding securities that are likely to be larger in market cap (Study Session 14, Module 29.4, LOS 29.f) Related Material en tre in SchweserNotes - Book Question #20 of 24 The chief investment o cer of a large endowment is considering allocating to a new core active bo ok c equity portfolio manager The endowment requires core active equity managers to have a large-cap value bias and has a benchmark equal to the NCSI World Equity Index The risk factor exposures of the benchmark and the custom portfolio of a potential new manager are displayed below: m Factor Exposures Size 0.92 -0.21 0.15 0.05 0.25 w Value 1.00 w w Market o NCSI World Index Custom Portfolio Which of the factor exposures is least likely to be consistent with a well-constructed portfolio? A) Market B) Size C) Value Explanation https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447526/print 13/16 10/12/2018 Learning Management System The requirements of the foundation are that core managers have a large cap value bias This is likely to lead to an allocation to more mature, larger companies creating a lower market beta, higher value factor exposure and more negative exposure to the size factor than the benchmark index (recall that the size factor exposure is generated through long exposure to smaller cap companies) Hence the positive exposure to the size factor here is a concern since it represents exposure to small cap companies which is not in line with the requirements of the foundation (Study Session 14, Module 29.5, LOS 29.g) Related Material in SchweserNotes - Book en tre Question #21 of 24 An analyst collects the following data regarding a portfolio of three securities: Covariance 10% 0.040000 0.012000 0.002400 Asset B 35% 0.012000 0.014400 0.001440 Asset C 55% 0.002400 0.001440 0.003600 bo ok c Asset A m Portfolio 100% 0.009520 0.007032 0.002724 w w A) 0.000952 o The contribution of Asset C to total portfolio variance is closest to: B) 0.002461 w C) 0.001498 Explanation Asset C's contribution to total portfolio variance = Weight of Asset A x weight of Asset C x Covariance of asset A with Asset C + Weight of Asset B x weight of Asset C x Covariance of asset B with Asset C + Weight of Asset C x weight of Asset C x Covariance of asset C with Asset C =(0.1 x 0.55 x 0.0024) + (0.35 x 0.55 x 0.001440) + (0.55 x 0.55 x 0.003600) = 0.001498 (Study Session 14, Module 29.3, LOS 29.d) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447526/print 14/16 10/12/2018 Learning Management System Question #22 of 24 Relative to discretionary active equity managers, systematic active equity managers will likely have A) Higher exposure to idiosyncratic risk B) Lower exposure to idiosyncratic risk C) Similar exposure to idiosyncratic risk in Explanation Related Material SchweserNotes - Book o m Question #23 of 24 bo ok c (Study Session 14, Module 29.1, LOS 29.b) en tre Systematic approaches to active equity management are more likely to design portfolios around extracting risk premiums from a balanced exposure to known, rewarded risk factors To achieve the desired factor exposure these systematic approaches use broadly diversi ed portfolios with low levels of idiosyncratic risk Conversely, discretionary managers tend to hold more concentrated portfolios and hence have higher levels of idiosyncratic risk w w Long extension strategies are best de ned as strategies that have: A) net exposure equal to zero w B) gross exposure equal to 100% C) net exposure equal to 100% Explanation A long extension strategy is de ned as having a net exposure (long positions – short positions) of 100% of investor's funds For example, this could be achieved by having a long portfolio equal to 130% of investors assets and shorting assets in value equal to 30% of investor's funds (giving a gross exposure of 130% + 30% = 160%) A net exposure of zero is a feature of an equity market neutral fund (Study Session 14, Module 29.5, LOS 29.h) Related Material SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447526/print 15/16 10/12/2018 Learning Management System Question #24 of 24 An active equity investment manager who holds no benchmark holdings in her portfolio will have an active share equal to: A) B) C) 0.5 in Explanation (Study Session 14, Module 29.2, LOS 29.c) bo ok c Related Material en tre Active Share takes a value between and If a manager holds a portfolio of stocks that are not in the benchmark, their active share equals 1, whereas if they hold the benchmark weights in their portfolio their Active Share will be If a portfolio has an Active Share of 0.5, we can conclude that 50% of the portfolio is identical to that of the benchmark and 50% is not w w w o m SchweserNotes - Book https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice/qbank/24038518/quiz/83447526/print 16/16 ... https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice /qbank/ 24 038 518/quiz/ 834 47526/print 5/16 10/12/2018 Learning Management System B) Active Share decreases and active risk increases C) Active Share and active risk both... https://www.kaplanlearn.com/education/dashboard/index/66a9ea0d62bb71ab495925615029a3fd/practice /qbank/ 24 038 518/quiz/ 834 47526/print 14/16 10/12/2018 Learning Management System Question #22 of 24 Relative to discretionary active equity managers, systematic active equity. .. Module 29 .3, LOS 29. d) en tre The contribution of a security to active variance is the product of the security's active weight and the covariance of the security's active returns and portfolio active